Fas 157 - Fair Value
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Fair Value Measurements SFAS 157 (973) 822-2220
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
2
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
3
Overview: SFAS 157 “Fair Value” I.
Reasons: A. B. C. D.
Over 60+ FASB standards depend upon fair value measurements Fair value definitions/approaches differ Fair value definition/guidance has been limited Has experienced an increased demand from users
4
Overview: SFAS 157 “Fair Value” 1)
Issues: A.
Different definitions and guidance in measurement of fair value in various standards has led to inconsistency and added to complexity in GAAP. 1.
B.
Statement 157 is principal guidance on fair value measurements
Need for more transparency in financial statements regarding fair value measurements. KEYPOINT • SFAS 157 does not require any new fair value measurements, but provides guidance on how to measure fair value.
5
Overview: SFAS 157 “Fair Value” 1.
Overview: A. B. C. D.
Defines fair value for financial reporting Approach for measuring fair value is established Disclosures about fair value are enhanced Effective for fiscal years beginning after November 15, 2007 (2008 for a calendar year-end entity)
KEYPOINT • Applies when other FASB standards require fair value
6
Overview: SFAS 157 “Fair Value” (i) SFAS 157: Definition of Fair Value A.
Defined: “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
7
Overview: SFAS 157 “Fair Value” 1)
Current Applications 1. 2. 3.
4.
SFAS 115 Investment securities SFAS 133 Derivative assets and liabilities SFAS 141 Certain assets and liabilities measured at fair value in a business combination (land and intangible assets) SFAS 142 & 144 Assets measured at fair value for an impairment test (longlived assets held for sale and goodwill)
8
Overview: SFAS 157 “Fair Value” i)
Use of SFAS 157 in the future A. B.
SFAS 157 shall apply to all future FASB statements that require or permit fair value. Upcoming statements: 1.
Business Combinations (141-R) will require fair value measurements for most assets and liabilities acquired, including: a. b. c.
2.
Contingent consideration Acquired contingent assets and liabilities Liabilities for restructuring or exit activities
The Fair Value Option for Financial Assets and Financial Liabilities will permit fair value measurements a. b. c. d.
Notes and mortgage receivables (assets) Issued debt (liabilities) Cost and equity method investments Certain insurance contracts
9
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
10
SFAS 157: Exceptions “scoped out” I.
The following exceptions were made to fair value measurements or similar measurements for transactions involving: A. B.
C.
SFAS 123R Share-based payments SAB 101/104, SOP 97-2, SOP 98-9, and EITF 00-21 Vendor-specific objective evidence and software revenue recognition ARB 43 Inventory (accounted for in accordance with ARB 43) KEYPOINT • SFAS 107 and FIN 45 – the Statement does not remove any practicability exceptions that currently exists in GAAP. 11
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
12
Unit of Accounting I.
Unit of Accounting A determination of whether as asset or liability that is measured at fair value is either: A. B.
A stand-alone asset or liability, or A group of assets and/or liabilities; depends on the unit of account which is determined in accordance with other applicable accounting standards. 1. 2.
Unit of account: Establishes the asset or liability that is being measured at fair value for purposes of financial reporting Unit of valuation Establishes whether the asset or liability is measured at fair value within a larger group KEYPOINT • Attribute the indicated fair value of the group to the asset or liability. 13
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
14
Considerations: Market-based Measures I.
Market-based Measures vs. Entity-specific Measures A. B. C.
Fair value is a market-based measure, not an entity-specific measure. The highest priority to quoted prices in active markets Permits the use of unobservable inputs for situations in which there is little, if any, market activity for the asset or liability being measured. KEYPOINT
•
A company should consider: i.
Risk inherent in a particular valuation technique (such as an option pricing model) and/or
ii.
Risk inherent in the inputs to the valuation technique
iii.
A valuation technique should include an adjustment for risk (if market participants would include such an adjustment in pricing a specific asset or liability)
15
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
16
Exit Price I.
Definition of Fair Value: Exit Market A. Exit Price 1. Price in hypothetical transaction to sell an asset or transfer a liability 2. Price at which a company would sell or otherwise dispose of its assets or pay to settle a liability (i.e., an exit)
17
Exit Price 1)
Entry Price 1. 2.
Not price in actual transaction to acquire an asset or assume a liability Not the market price that a company acquires or assumes a liability (i.e., not an entry) KEYPOINT
•
The exit price concept is based on current expectations about the future inflows associated with the asset and the future outflows associated with the liability from the perspective of market participants.
•
A fair value measure should reflect all of the assumptions that market participants would use pricing the asset or liability
Example: An adjustment for risk inherent in a particular market
18
Exit Price A.
Transaction Costs 1.
Not adjusted for transaction costs
KEYPOINT •
Financial institution industry will likely elect early adoption due to the SFAS 157 requirement, “Not Adjusted” for transaction costs.
19
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
20
Market Participants I.
Market Participants Buyers and sellers, in an exit market (other entities with whom the company would transact), that are independent (unrelated / SFAS 57), able, and willing to transact A. B.
Skepticism of a risk averse buyer. Fair value should reflect how market participants would value the asset, even if market participants would use the asset differently than the owner’s intended use.
21
Market Participants 1)
Fair value measurement should be determined based on assumptions market participants would use in pricing the asset or liability, including A. B. C.
Assumptions about risk Highest and best use (if asset) Nonperformance risk (if liability)
• Fair value measures use the perspective of a market participant and their assumptions used to price an asset or liability. • Determining market participant assumptions will require management to use a significant amount of judgment. • Note: Management is permitted to use their own data to measure the fair value of an asset or liability, however, such data should be adjusted if there is reasonably available information that indicates market participants would use different assumptions. 22
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
23
Orderly Transaction I.
Orderly Transaction A. B. C. D.
Presumes that an asset or liability is exposed to the market to allow for usual and customary marketing activities. Not based on a transaction that is a forced sale, a liquidation transaction, or a distress sale. Based on an orderly transaction reflecting market conditions on the measurement date. In the absence of an actual transaction, the fair value is measured based on a hypothetical transaction between market participants and reflects market participant assumptions.
24
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
25
Highest Use / Principal Market I.
Fair value measurement assumes transaction occurs in the principal (or most advantageous) market: A.
Step 1 1.
B.
Principal market The market with the greatest volume and level of activity for asset or liability
Step 2 1.
Most Advantageous Market If there is no principal market, look to the most advantageous market a. b.
Most advantageous market Maximizes the amount that would be received for the asset, or Minimizes the amount that would be paid to transfer the liability, considering transaction costs
26
Highest Use / Principal Market KEYPOINT •
Determining the appropriate market is done from the perspective of the company, thereby allowing for differences among companies and the markets in which those companies transact.
•
If there is a principal market for the asset or liability, the price in that market should be used to measure fair value even if the price in a different market is potentially more advantageous at the measurement date.
•
The principal market should represent the most advantageous market and company is not required to continuously evaluate multiple prices for an asset or a liability in order to determine the most advantageous market
•
Summary: The price from the most advantageous market should be used only when there is no principal market for the asset or liability.
27
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
28
Transaction / Transportation I.
Transaction Costs A.
Definition Incremental direct cost to sell an asset or transfer a liability (similar to cost to sell in Statement 144) 1.
B.
Include in Fair Value: No. Follow other GAAP for how to account for transaction costs. 1.
II.
Example: Broker’s commissions and fees
Note: If no GAAP guidance, then expense.
Transportation Costs A.
B.
Definition The costs incurred to transport the asset or liability to (or from) its principal (or most advantageous) market. Include in Fair Value: Yes, if location is a characteristic of the asset or liability (a commodity such as oil).
29
Transaction / Transportation
KEYPOINT •
The cost of transporting a physical-commodity from its current location to the market should be deducted in the computation of fair value that is based on the price in that market.
•
A broker’s commission to access an equity securities market should not be considered in measuring the fair value of an equity security.
30
Transaction Costs: Illustration 1 ILLUSTRATION 1 • •
•
Gearty Inc. holds Foxy Co. stock, which trades on two exchanges (Gearty Inc. can access both the New York and London markets) The stock price and transaction costs at the measurement date: Exchange
Quoted Stock Price
Transaction Costs
Net
New York
$52
$(6)
$46
London
$50
$(2)
$48
What is the fair value of Foxy Stock? • • •
If New York is the principal market = $52 If London is the principal market = $50 If no principal market, since London’s price (net of transaction costs) is the most advantageous result
=
$50
31
Transaction Costs: Illustration 2 ILLUSTRATION 2 •
Multiple active markets for financial assets with observance different prices Transaction
•
•
Market
Price
Transaction Costs
Net Amount
A
$76
$(5)
$71
B
$74
$(2)
$72
Market A If Market A is the principal market for the asset, the fair value measurement based on Market A price ($76) Market B If neither market is the principal market for the asset, the fair value measurement based on Market B price ($74) because that market is the most advantageous market for the asset, considering transaction costs KEYPOINT
•
Fair value measurement is NOT adjusted for transaction costs 32
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
33
Fair Value Assets I.
Rule A. B.
II.
The fair value for an asset is the asset’s highest and best use from the perspective of market participants which would maximize a company’s future cash inflows Note: The company’s intended use of an asset is not necessarily indicative of the highest and best use as determined by a market participant.
Rule A.
The fair value measure is not an entity-specific measure that reflects only the company’s expectations for the asset. KEYPOINT
Fair value “in use” •
The highest and best use of an asset is in-use if the asset would provide maximum value to market participants through its use with other assets as a group.
•
The in-use valuation is still a market-based measure determined based on the use of the asset by market participants, not a value determined based solely on the use of the asset by the company (not an entity-specific measure). 34
Fair Value Assets 1.
IPR&D: “In-use” vs. “in exchange” A. B.
Example: Foxy Co. acquires IPR&D project: Highest and best use/valuation premise 1.
In-use: a.
b. c.
2.
When IPR&D project would provide maximum value to market participants through its use together with other assets as a group Use encompasses use as a completed project or as a lockedup project Provide defensive value
In-exchange: a. b.
When IPR&D project would provide maximum value to market participants through its non use Discontinue development
35
Fair Value Assets (i) Special Rules A.
Investment Block Discounts 1.
2.
Definition: A blockage factor is a discount applied to the security price to reflect the lack of trading volume in the market for the security to absorb the sale of a large block without impacting the security’s price. New Rule: SFAS 157 does not allow this. The fair value of quoted securities will be equal to the price multiplied by the quantity, without any adjustment to reflect a blockage factor.
36
Fair Value Assets 1)
Restricted Securities 1.
Old Rule: SFAS 115 a. b.
c.
2.
Applies to equity securities for which sale is restricted for a period less than one year. It did not permit companies to reduce the quoted price of an identical but unrestricted security to reflect the impact of the restriction. More than one year are outside the scope of SFAS 115
New Rule: SFAS 157 Requires companies to reduce the quoted price of an identical unrestricted security to reflect the impact of the restriction regardless of whether the restriction is for less than one year or more than one year.
37
Fair Value Assets 1.
EITF Issue 02-3 (Day One Gain/Loss Accounting) will be superseded 1.
Old Rule: a. b.
2.
A dealer cannot recognize Day 1 Profit if a derivative contract’s fair value is not based on observable market data. Day 1 dealer profit is the unrealized gain or loss resulting from the difference between the transaction price of a derivative instrument and the fair value of the instrument at initial recognition.
New Rule: SFAS 157 specifies that in certain cases, the transaction price may not be representative of fair value. In those cases, the company might measure fair value using a valuation technique and recognize initial profit (or loss) even if the measure of the derivative’s fair value is based on the dealer’s valuation model and that model uses significant entity-specific inputs.
38
Fair Value Assets (i)
Bid & Ask Prices (SEC Accounting Series Release No. 118 / ASR 118) 1.
General Rule: a.
2.
Use a price within the bid ask spread that is most representative of fair value (consistently applied)
Default Rule: Mid-market pricing or other pricing conventions may be used as a practical expedient for fair value measurements within a bid-ask spread.
KEYPOINT
The following would be permitted: •
Assets: Bid price for long positions
•
Liabilities: Asking price for short positions
39
Fair Value Assets EXAMPLE • • •
Foxy Co. (securities dealer) enters into interest rate swap with Gearty Co. (retail counterparty) in retail market for no initial consideration. Foxy Co. would transfer its rights and obligations under the swap to a securities dealer counterparty in the inter-dealer market, not a retail counterparty in the retail market At initial recognition, the transaction price (entry price) might NOT represent fair value of the swap (exit price) KEYPOINT
SFAS 157 nullifies EITF Issue 02-3 (Footnote 3)
40
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
41
Fair Value Liabilities I.
General Rule A.
B. C. D.
A fair value measure presumes that the liability is transferred to a market participant at the measurement date and that the nonperformance risk relating to the liability is the same before and after its transfer. Nonperformance risk is risk that the obligation will not be fulfilled (affects the value at which the liability is transferred/company’s own credit risk) The measure should reflect the market participants’ measure of discounted future cash outflows (for the liability) In assessing the effect of non-performance risk, management should consider the terms of any collateral and other credit enhancements that are specified in the contract for the liability that is being measured. KEYPOINT
Impact will differ depending on the terms of any credit enhancements (for example, cash collateral)
42
Fair Value Liabilities 1)
Special Rule A.
B.
The Effect of Changes in Credit Risk on a Fair Value Measure: In measuring the fair value of a liability, a company should take into account the effect of its own credit standing. Counterintuitive result: As an entity’s credit standing is remeasured, the fair value of its liabilities will result in earnings reported on the income statement: 1. 2.
Gains = for credit downgrades Losses = for credit upgrades KEYPOINT
These results may indicate that fair value may not be the appropriate measure for a liability in certain circumstances.
43
Fair Value Liabilities 1.
Liabilities: Fair Value Illustration ILLUSTRATION
1) 2)
Foxy Bank (investment bank with AA credit rating) issues 5-year fixed rate note to Gearty Inc. Fair value measurement considers: • • •
Nonperformance risk, including credit risk Changes in credit spreads (generally even if no changes in specific credit risk) Changes in specific credit risk (even if within the AA spread)
44
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
45
Fair Value Approaches I.
SFAS 157 describes three available techniques to measuring fair value A.
B.
Market Approach: Identify observable prices and other relevant information that is generated by market transactions involving identical or comparable assets or liabilities. Income Approach: Use valuation techniques to convert future amounts (cash flows or earnings) to a single, discounted amount. The fair value measure is based on the value that is indicated by market expectations about the future amounts. The income approach includes presentvalue techniques/option-pricing models: 1. 2. 3.
Black-Scholes Binomial models – lattice models Multi-period excess-earnings method (CON 7 specifies that adjustments reflecting systematic risk can be made to either (1) the expected cash flows or (2) the discounted rate. The risk-free rate would be an appropriate discount rate only if the adjustment that reflects the systematic risk (non-diversifiable risk) is reflected in the expected cash flows)
46
Fair Value Approaches
• Measure fair value by a valuation technique that is appropriate and for which sufficient data is available. • Multiple valuation techniques: Management should evaluate and weigh the results to determine a single best fair value measure. • The weighting process should not be mechanical and requires a significant amount of professional judgment. • Techniques used to measure fair value should be applied consistently. It is appropriate to change when the change will result in a measure that better represents fair value.
47
Fair Value Approaches ILLUSTRATION 1)
Foxy Co. is testing land and a retail store to be held and used for the purposes of impairment under SFAS 144. A two-step test is required: 1)
2)
Step 1: Foxy Co. projects cash flows it expects to realize from operating the asset group and determines that the carrying value of the asset group is not recoverable. Step 2: Foxy Co. discounts the same cash flows used in Step 1 and arrives at a value.
KEYPOINT
Determining fair value by simply discounting cash flows based on Foxy Co.’s intended use of the facility may not comply with SFAS 157.
Foxy Co. should consider whether recent sales of comparable retail stores in the area have closed at higher or lower amounts.
48
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
49
Fair Value Hierarchy – Overview I.
SFAS 157, “Fair Value Measurements” establishes a three-level hierarchy. The purpose of the hierarchy: A. B. C.
To increase consistency and comparability in fair value measures. To maximize the use of observable market data and minimize the use of unobservable inputs. To establish classification of fair value measurements for disclosure purposes.
50
Fair Value Hierarchy – Overview 1)
Input Valuation Techniques: A.
Market participant assumptions are incorporated in the fair value measurement through the inputs to valuation techniques 1.
2.
Observable inputs: Developed based on market data obtained from sources independent of the reporting entity/company Unobservable inputs: Developed based on the best information available in the circumstances, subject to cost-benefit constraint KEYPOINT
A fair value measurement should maximize the use of observable inputs
51
Fair Value Hierarchy – Overview 1)
Types of Markets (within Observable Inputs) Markets in which inputs might be observable include: 1.
Exchange Market In an “active” exchange market, closing prices are both readily available and representative of fair value a.
2.
Dealer Market: Dealers stand ready to trade for their own account; the dealers provide liquidity by using their capital to hold an inventory of the items for which these dealers make a market. Usually bid prices and asked prices are more readily available than closing prices. a.
3.
4.
Example: New York Stock Exchange
Examples: Financial instruments, commodities, physical assets
Brokered Market: Brokers attempt to match buyers with sellers. Brokers do not stand ready to trade for their own account and they will not use their own capital to hold an inventory of the items for a market. Principal-to-Principal Market: These transactions (both originations and resales) are negotiated independently, with no intermediary. Typically, there is very little information about these transactions is publicly available.
52
Fair Value Hierarchy – Overview 1.
Fair Value Hierarchy:
Level 1
Observable inputs that reflect quoted prices in active markets for identical assets/liabilities (unadjusted)
Foxy Inc.’s common stock traded and quoted on the New York Stock Exchange
• A privately placed bond of Foxy Inc., the value is derived from a similar bond that is publicly traded Directly or indirectly observable (market-based) inputs – including quoted Level 2 prices for similar assets/liabilities (adjusted) through corroboration and • An over-the-counter interest rate swap, observable market data inputs valued based on a model whose inputs are observable LIBOR forward interest rate curves. • Shares of Gearty Co., a privately held company whose value is based on Unobservable inputs (no market data, not correlated with market data) – projected cash flows. company’s own data assumptions about market participant assumptions, • A long-dated commodity swap whose Level 3 including assumptions about risk, developed based on the best forward price curve, used in a information available in the circumstances (can include the entity’s own valuation model, is not directly data inputs) observable or correlated with observable market data.
KEYPOINT Subject to cost-benefit constraints
• Level 3 is most “subjective” and therefore of greatest risk of manipulation 53
Fair Value Hierarchy – Overview
KEYPOINT The selection of appropriate valuation techniques may be affected by the availability of inputs that are relevant to the asset or the liability, as well as be affected by the relative reliability of the inputs.
• By distinguishing between inputs that are observable in the marketplace and therefore more objective and those that are unobservable and therefore more subjective, the hierarchy is designed to indicate the relative reliability of the fair value measures.
54
Fair Value Hierarchy – Overview
KEYPOINT In some cases, inputs might fall within different levels of the fair value hierarchy. The lowest level of significant input determines the placement of a fair value measure in the hierarchy. Assessing the significance of a particular input requires judgment, important for disclosures
• Certain disclosure required by SFAS 157 are applicable only to those fair value measures that use Level 3 inputs
55
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
56
Fair Value Hierarchy – Level 1 I.
Level 1 Inputs A. B. C.
Level 1 inputs are quoted prices (unadjusted) for identical assets or liabilities in active markets. Provides the most reliable fair value measure Level 1 should be used provided that 1. 2.
The market is the principal (or the most advantageous) market, and The company has the ability to access the principal (or the most advantageous) market. a.
Example: If a retail customer that does not have access to wholesale market, then the quoted prices in the wholesale market will not qualify as Level 1 inputs for that company.
57
Fair Value Hierarchy – Level 1
KEYPOINT
Matrix Pricing: i. A company may measure fair value by using matrix pricing, provided that the company demonstrates that the method replicates actual prices. ii. Used to value debt securities by relying on the securities’ relationship to other benchmark quoted prices. iii. The resulting measure will be a Level 2 input. iv. Matrix pricing is a very common approach for such things as valuing bond portfolios.
58
Fair Value Hierarchy – Level 1 1)
Modification of Transaction Price Presumption A.
Fair value may not equal the transaction price when: 1. 2. 3. 4.
Related parties make the transaction Bankruptcy: the transaction is done under duress (or some other urgency) Unit of account differences (transaction price includes transaction costs) The transaction is not in Principal (or most advantageous) market (retail market vs. wholesale market)
59
Fair Value Hierarchy – Level 1 KEYPOINT SFAS 153: Non-monetary Exchanges (Fair Value) i. An asset is acquired or a liability is assumed in an exchange transaction – the transaction price represents the price that was paid for the asset or that was received to assume the liability (i.e., the entry price). ii. The fair value of the asset or the liability represents the price that would be received for the asset or paid to transfer the liability (i.e., the exit price) iii. The above two prices can be different.
60
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
61
Fair Value Hierarchy – Level 2 I.
Level 2 Inputs When an asset or liability has a specified (contractual) term, a Level 2 input should be observable for substantially the full term of the asset or liability. They include the following: A. B. C.
D. E. F. G.
Quoted prices for “similar” assets or liabilities in active markets Quoted prices for “identical” or “similar” assets or liabilities in markets that are not active. Not Active Markets: 1. 2. 3. 4.
Few transactions for the asset or liability Prices are not current Price quotations vary substantially either over time or among market Little information is publicly available
Inputs other than quoted price that are observable for the asset or liability (interest rates and yield curves observable at commonly quoted intervals, volatilities , prepayment speeds, and default rates) Inputs that are derived principally from or corroborated by other observable market data through correlation or by other means. Adjustments of Level 2 inputs should reflect factors such as the condition and/or location and the volume and level of activity in the markets within which the inputs are observed. An adjustment that is significant might place the measure at Level 3 in the fair value hierarchy.
62
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
63
Fair Value Hierarchy – Level 3 I.
Level 3 Inputs A.
B.
C. D.
Level 3 inputs are unobservable inputs that consider the assumptions that market participants would use in pricing the asset or liability, including assumptions about risk. Unobservable inputs should be developed based on the best information available in the circumstances, which might include the company’s own data. A company need not undertake all possible efforts to obtain information about market participant assumptions The company should not ignore market participant assumptions that are reasonably available without undue cost and effort.
64
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
65
Unit of Valuation I.
Definitions A.
B.
Unit of accounting Establishes the asset or liability that is being measured at fair value for purposes of financial reporting. Unit of valuation Establishes whether the asset or liability is measured at fair value within a larger group
KEYPOINT Attribute the indicated fair value of the group to the asset or liability.
66
Unit of Valuation 1)
Unit of Valuation
Depends on the “highest and best use” of the asset, which establishes the “valuation premise” used to measure the fair value of the asset. A. Highest and Best Use Use by market participants that maximizes value of asset (or asset group). B. Valuation Premise 1.
In-Use: Market Participant Synergies Highest and best use is “in-use” if: a.
2.
Asset would provide maximum value to market participants through its use with other assets as a group, as installed or otherwise configured for use.
In Exchange: No Market Participant Synergies Highest and best use is “in-exchange” if: a.
Asset would provide maximum value to market participants through its use on a stand-alone basis
67
Unit of Valuation 1.
Highest Use: Real property Illustration 1 ILLUSTRATION 1
• • •
•
Foxy Co. acquires land and storage building. Observable market data indicates that nearby sites have recently been developed for residential use. The highest and best use of the land would be determined by comparing: 1) The fair value of the storage building (in-use) 2) The fair value of the land as a vacant site for condominiums (in-exchange) Regardless of the intended use, the highest and best use of the land would be determined based on the higher of those values
KEYPOINT
Highest and best use assumptions should be consistently applied to other assets in the asset group. Note: The land’s highest and best use would determine the storage building’s highest and best use.
68
Unit of Valuation (i) Asset Group: Illustration 2 ILLUSTRATION 2 •
Foxy Co. acquires assets that are used together as a group (Assets X,Y, and Z). • • • • • • • •
Unit of account = each individual asset Unit of valuation = the group of assets within which the assets would be best used by market participants Highest and best use is in-use Exit market = the acquisition market Market participants are other bidders for the assets Strategic and financial buyers Strategic buyers have related assets that would enhance the value of the assets as a group, including a replacement asset for Asset Z (billing software) Financial buyers do not have related assets that would enhance the value of the assets as a group.
69
Unit of Valuation I.
Asset Group: Illustration 2 (continued) ILLUSTRATION 2 (continued) Observable Fair Value Assets Strategic Buyer Group
• •
Financial Buyer Group
X
$820
$700
Y
$620
$500
Z
$160
$300
Total
$1,600
$1,500
Fair values of Assets X, Y, and Z determined based on use within strategic buyer group because that use would maximize the fair value of Assets X, Y, and Z as a group. Do not maximize the fair value of each asset individually
70
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
71
Reporting Requirements I.
New Disclosures A. B. C. D. E.
Improve transparency regarding how fair value is determined. Applies to both recurring (example: SFAS 115) and non-recurring (example: SFAS 144) fair value measurements of assets and liabilities Tabular disclosure by major category of which level in the hierarchy a fair value measurement falls Annually (and in the period of adoption), describe the valuation techniques and any changes to the valuation techniques. Provide disclosures about: 1. 2. 3. 4.
The extent to which companies measure assets and liabilities at fair value The methods and assumptions used to measure fair value The effect of fair value measures on earnings Expanded disclosures about Level 3 (non-market data) measures: a. b.
Each major category of assets and liabilities measured using a Level 3 fair value measure, a reconciliation of beginning and ending balances including total gains and losses The amount of total gains and losses attributable to the changes in unrealized gains and losses related to Level 3 input-based assets and liabilities held at the reporting date and a description of where those gains and losses are reported in the income statement.
72
Reporting Requirements ILLUSTRATION: Disclosure – Recurring 1 Fair Value at Reporting Date Level 1:
Level 2:
Level 31:
12/31/XX
Quoted prices in active markets for identical assets
Significant other observable inputs
Significant unobservable inputs
$115
$105
$10
-0-
Available-for-Sale securities
75
75
-0-
-0-
Derivatives
60
25
152
$203
Venture capital investments
10
-0-
-0-
$10
$260
$205
$25
$30
Description Trading Securities
Total
Additional disclosures are required for recurring Level 3 measurements 2 Standard interest rate swaps 3 20 year energy contract 1
73
Reporting Requirements ILLUSTRATION: Level 3 Recurring Level 3: Assets Measured on a Recurring Basis Using Significant Unobservable Inputs
Beginning Balance 01/01/XX Total gains or losses (realized / unrealized): Income Statement Included in Other Comprehensive Income Purchases, issuances and settlements Transfers in and/or out of Level 3 Ending Balance 12/31/XX Unrealized gain (loss) in earnings from assets still held at period end
Derivatives*
Investments by Venture Capitalist
Total
$14
$11
$25
11 4 (7) (2) $20 $ 7
(3) -02 -0$10 $ 2
8 4 (5) (2) $30 $ 9
KEYPOINT
*Derivatives assets and liabilities can be presented net for purposes of this roll-forward.
74
Reporting Requirements ILLUSTRATION: Nonrecurring* Level 3: Assets Measured on a Recurring Basis Using Significant Unobservable Inputs
Description
End of Year 12/31/XX
Level 1 Level 2 Level 3 Quoted prices in Significant other Significant active markets for observable unobservable identical assets inputs inputs
Total Gains (Losses)
Long-lived assets held and used
$225
-0-
$225
-0-
($75)
Goodwill
$90
-0-
-0-
$90
($40)
Total
($115) KEYPOINT Describe the reason for the nonrecurring fair value measurement Describe the inputs and information used to develop the inputs for nonrecurring Level 3 based fair value measurements. 75
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
76
Transition I. Prospective II. Two Exceptions: Cumulative effect adjustments to beginning retained earnings in year of initial application: A. B.
Block discounts Issue 02-3 and Statement 155 hybrid instrument day-one gain and loss deferrals
III. Effective for fiscal years beginning after November 15, 2007. (Calendar year business will be required to apply SFAS starting on January 1, 2008).
77
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
2
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
3
Overview: SFAS 157 “Fair Value” I.
Reasons: A. B. C. D.
Over 60+ FASB standards depend upon fair value measurements Fair value definitions/approaches differ Fair value definition/guidance has been limited Has experienced an increased demand from users
4
Overview: SFAS 157 “Fair Value” 1)
Issues: A.
Different definitions and guidance in measurement of fair value in various standards has led to inconsistency and added to complexity in GAAP. 1.
B.
Statement 157 is principal guidance on fair value measurements
Need for more transparency in financial statements regarding fair value measurements. KEYPOINT • SFAS 157 does not require any new fair value measurements, but provides guidance on how to measure fair value.
5
Overview: SFAS 157 “Fair Value” 1.
Overview: A. B. C. D.
Defines fair value for financial reporting Approach for measuring fair value is established Disclosures about fair value are enhanced Effective for fiscal years beginning after November 15, 2007 (2008 for a calendar year-end entity)
KEYPOINT • Applies when other FASB standards require fair value
6
Overview: SFAS 157 “Fair Value” (i) SFAS 157: Definition of Fair Value A.
Defined: “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
7
Overview: SFAS 157 “Fair Value” 1)
Current Applications 1. 2. 3.
4.
SFAS 115 Investment securities SFAS 133 Derivative assets and liabilities SFAS 141 Certain assets and liabilities measured at fair value in a business combination (land and intangible assets) SFAS 142 & 144 Assets measured at fair value for an impairment test (longlived assets held for sale and goodwill)
8
Overview: SFAS 157 “Fair Value” i)
Use of SFAS 157 in the future A. B.
SFAS 157 shall apply to all future FASB statements that require or permit fair value. Upcoming statements: 1.
Business Combinations (141-R) will require fair value measurements for most assets and liabilities acquired, including: a. b. c.
2.
Contingent consideration Acquired contingent assets and liabilities Liabilities for restructuring or exit activities
The Fair Value Option for Financial Assets and Financial Liabilities will permit fair value measurements a. b. c. d.
Notes and mortgage receivables (assets) Issued debt (liabilities) Cost and equity method investments Certain insurance contracts
9
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
10
SFAS 157: Exceptions “scoped out” I.
The following exceptions were made to fair value measurements or similar measurements for transactions involving: A. B.
C.
SFAS 123R Share-based payments SAB 101/104, SOP 97-2, SOP 98-9, and EITF 00-21 Vendor-specific objective evidence and software revenue recognition ARB 43 Inventory (accounted for in accordance with ARB 43) KEYPOINT • SFAS 107 and FIN 45 – the Statement does not remove any practicability exceptions that currently exists in GAAP. 11
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
12
Unit of Accounting I.
Unit of Accounting A determination of whether as asset or liability that is measured at fair value is either: A. B.
A stand-alone asset or liability, or A group of assets and/or liabilities; depends on the unit of account which is determined in accordance with other applicable accounting standards. 1. 2.
Unit of account: Establishes the asset or liability that is being measured at fair value for purposes of financial reporting Unit of valuation Establishes whether the asset or liability is measured at fair value within a larger group KEYPOINT • Attribute the indicated fair value of the group to the asset or liability. 13
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
14
Considerations: Market-based Measures I.
Market-based Measures vs. Entity-specific Measures A. B. C.
Fair value is a market-based measure, not an entity-specific measure. The highest priority to quoted prices in active markets Permits the use of unobservable inputs for situations in which there is little, if any, market activity for the asset or liability being measured. KEYPOINT
•
A company should consider: i.
Risk inherent in a particular valuation technique (such as an option pricing model) and/or
ii.
Risk inherent in the inputs to the valuation technique
iii.
A valuation technique should include an adjustment for risk (if market participants would include such an adjustment in pricing a specific asset or liability)
15
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
16
Exit Price I.
Definition of Fair Value: Exit Market A. Exit Price 1. Price in hypothetical transaction to sell an asset or transfer a liability 2. Price at which a company would sell or otherwise dispose of its assets or pay to settle a liability (i.e., an exit)
17
Exit Price 1)
Entry Price 1. 2.
Not price in actual transaction to acquire an asset or assume a liability Not the market price that a company acquires or assumes a liability (i.e., not an entry) KEYPOINT
•
The exit price concept is based on current expectations about the future inflows associated with the asset and the future outflows associated with the liability from the perspective of market participants.
•
A fair value measure should reflect all of the assumptions that market participants would use pricing the asset or liability
Example: An adjustment for risk inherent in a particular market
18
Exit Price A.
Transaction Costs 1.
Not adjusted for transaction costs
KEYPOINT •
Financial institution industry will likely elect early adoption due to the SFAS 157 requirement, “Not Adjusted” for transaction costs.
19
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
20
Market Participants I.
Market Participants Buyers and sellers, in an exit market (other entities with whom the company would transact), that are independent (unrelated / SFAS 57), able, and willing to transact A. B.
Skepticism of a risk averse buyer. Fair value should reflect how market participants would value the asset, even if market participants would use the asset differently than the owner’s intended use.
21
Market Participants 1)
Fair value measurement should be determined based on assumptions market participants would use in pricing the asset or liability, including A. B. C.
Assumptions about risk Highest and best use (if asset) Nonperformance risk (if liability)
• Fair value measures use the perspective of a market participant and their assumptions used to price an asset or liability. • Determining market participant assumptions will require management to use a significant amount of judgment. • Note: Management is permitted to use their own data to measure the fair value of an asset or liability, however, such data should be adjusted if there is reasonably available information that indicates market participants would use different assumptions. 22
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
23
Orderly Transaction I.
Orderly Transaction A. B. C. D.
Presumes that an asset or liability is exposed to the market to allow for usual and customary marketing activities. Not based on a transaction that is a forced sale, a liquidation transaction, or a distress sale. Based on an orderly transaction reflecting market conditions on the measurement date. In the absence of an actual transaction, the fair value is measured based on a hypothetical transaction between market participants and reflects market participant assumptions.
24
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
25
Highest Use / Principal Market I.
Fair value measurement assumes transaction occurs in the principal (or most advantageous) market: A.
Step 1 1.
B.
Principal market The market with the greatest volume and level of activity for asset or liability
Step 2 1.
Most Advantageous Market If there is no principal market, look to the most advantageous market a. b.
Most advantageous market Maximizes the amount that would be received for the asset, or Minimizes the amount that would be paid to transfer the liability, considering transaction costs
26
Highest Use / Principal Market KEYPOINT •
Determining the appropriate market is done from the perspective of the company, thereby allowing for differences among companies and the markets in which those companies transact.
•
If there is a principal market for the asset or liability, the price in that market should be used to measure fair value even if the price in a different market is potentially more advantageous at the measurement date.
•
The principal market should represent the most advantageous market and company is not required to continuously evaluate multiple prices for an asset or a liability in order to determine the most advantageous market
•
Summary: The price from the most advantageous market should be used only when there is no principal market for the asset or liability.
27
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
28
Transaction / Transportation I.
Transaction Costs A.
Definition Incremental direct cost to sell an asset or transfer a liability (similar to cost to sell in Statement 144) 1.
B.
Include in Fair Value: No. Follow other GAAP for how to account for transaction costs. 1.
II.
Example: Broker’s commissions and fees
Note: If no GAAP guidance, then expense.
Transportation Costs A.
B.
Definition The costs incurred to transport the asset or liability to (or from) its principal (or most advantageous) market. Include in Fair Value: Yes, if location is a characteristic of the asset or liability (a commodity such as oil).
29
Transaction / Transportation
KEYPOINT •
The cost of transporting a physical-commodity from its current location to the market should be deducted in the computation of fair value that is based on the price in that market.
•
A broker’s commission to access an equity securities market should not be considered in measuring the fair value of an equity security.
30
Transaction Costs: Illustration 1 ILLUSTRATION 1 • •
•
Gearty Inc. holds Foxy Co. stock, which trades on two exchanges (Gearty Inc. can access both the New York and London markets) The stock price and transaction costs at the measurement date: Exchange
Quoted Stock Price
Transaction Costs
Net
New York
$52
$(6)
$46
London
$50
$(2)
$48
What is the fair value of Foxy Stock? • • •
If New York is the principal market = $52 If London is the principal market = $50 If no principal market, since London’s price (net of transaction costs) is the most advantageous result
=
$50
31
Transaction Costs: Illustration 2 ILLUSTRATION 2 •
Multiple active markets for financial assets with observance different prices Transaction
•
•
Market
Price
Transaction Costs
Net Amount
A
$76
$(5)
$71
B
$74
$(2)
$72
Market A If Market A is the principal market for the asset, the fair value measurement based on Market A price ($76) Market B If neither market is the principal market for the asset, the fair value measurement based on Market B price ($74) because that market is the most advantageous market for the asset, considering transaction costs KEYPOINT
•
Fair value measurement is NOT adjusted for transaction costs 32
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
33
Fair Value Assets I.
Rule A. B.
II.
The fair value for an asset is the asset’s highest and best use from the perspective of market participants which would maximize a company’s future cash inflows Note: The company’s intended use of an asset is not necessarily indicative of the highest and best use as determined by a market participant.
Rule A.
The fair value measure is not an entity-specific measure that reflects only the company’s expectations for the asset. KEYPOINT
Fair value “in use” •
The highest and best use of an asset is in-use if the asset would provide maximum value to market participants through its use with other assets as a group.
•
The in-use valuation is still a market-based measure determined based on the use of the asset by market participants, not a value determined based solely on the use of the asset by the company (not an entity-specific measure). 34
Fair Value Assets 1.
IPR&D: “In-use” vs. “in exchange” A. B.
Example: Foxy Co. acquires IPR&D project: Highest and best use/valuation premise 1.
In-use: a.
b. c.
2.
When IPR&D project would provide maximum value to market participants through its use together with other assets as a group Use encompasses use as a completed project or as a lockedup project Provide defensive value
In-exchange: a. b.
When IPR&D project would provide maximum value to market participants through its non use Discontinue development
35
Fair Value Assets (i) Special Rules A.
Investment Block Discounts 1.
2.
Definition: A blockage factor is a discount applied to the security price to reflect the lack of trading volume in the market for the security to absorb the sale of a large block without impacting the security’s price. New Rule: SFAS 157 does not allow this. The fair value of quoted securities will be equal to the price multiplied by the quantity, without any adjustment to reflect a blockage factor.
36
Fair Value Assets 1)
Restricted Securities 1.
Old Rule: SFAS 115 a. b.
c.
2.
Applies to equity securities for which sale is restricted for a period less than one year. It did not permit companies to reduce the quoted price of an identical but unrestricted security to reflect the impact of the restriction. More than one year are outside the scope of SFAS 115
New Rule: SFAS 157 Requires companies to reduce the quoted price of an identical unrestricted security to reflect the impact of the restriction regardless of whether the restriction is for less than one year or more than one year.
37
Fair Value Assets 1.
EITF Issue 02-3 (Day One Gain/Loss Accounting) will be superseded 1.
Old Rule: a. b.
2.
A dealer cannot recognize Day 1 Profit if a derivative contract’s fair value is not based on observable market data. Day 1 dealer profit is the unrealized gain or loss resulting from the difference between the transaction price of a derivative instrument and the fair value of the instrument at initial recognition.
New Rule: SFAS 157 specifies that in certain cases, the transaction price may not be representative of fair value. In those cases, the company might measure fair value using a valuation technique and recognize initial profit (or loss) even if the measure of the derivative’s fair value is based on the dealer’s valuation model and that model uses significant entity-specific inputs.
38
Fair Value Assets (i)
Bid & Ask Prices (SEC Accounting Series Release No. 118 / ASR 118) 1.
General Rule: a.
2.
Use a price within the bid ask spread that is most representative of fair value (consistently applied)
Default Rule: Mid-market pricing or other pricing conventions may be used as a practical expedient for fair value measurements within a bid-ask spread.
KEYPOINT
The following would be permitted: •
Assets: Bid price for long positions
•
Liabilities: Asking price for short positions
39
Fair Value Assets EXAMPLE • • •
Foxy Co. (securities dealer) enters into interest rate swap with Gearty Co. (retail counterparty) in retail market for no initial consideration. Foxy Co. would transfer its rights and obligations under the swap to a securities dealer counterparty in the inter-dealer market, not a retail counterparty in the retail market At initial recognition, the transaction price (entry price) might NOT represent fair value of the swap (exit price) KEYPOINT
SFAS 157 nullifies EITF Issue 02-3 (Footnote 3)
40
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
41
Fair Value Liabilities I.
General Rule A.
B. C. D.
A fair value measure presumes that the liability is transferred to a market participant at the measurement date and that the nonperformance risk relating to the liability is the same before and after its transfer. Nonperformance risk is risk that the obligation will not be fulfilled (affects the value at which the liability is transferred/company’s own credit risk) The measure should reflect the market participants’ measure of discounted future cash outflows (for the liability) In assessing the effect of non-performance risk, management should consider the terms of any collateral and other credit enhancements that are specified in the contract for the liability that is being measured. KEYPOINT
Impact will differ depending on the terms of any credit enhancements (for example, cash collateral)
42
Fair Value Liabilities 1)
Special Rule A.
B.
The Effect of Changes in Credit Risk on a Fair Value Measure: In measuring the fair value of a liability, a company should take into account the effect of its own credit standing. Counterintuitive result: As an entity’s credit standing is remeasured, the fair value of its liabilities will result in earnings reported on the income statement: 1. 2.
Gains = for credit downgrades Losses = for credit upgrades KEYPOINT
These results may indicate that fair value may not be the appropriate measure for a liability in certain circumstances.
43
Fair Value Liabilities 1.
Liabilities: Fair Value Illustration ILLUSTRATION
1) 2)
Foxy Bank (investment bank with AA credit rating) issues 5-year fixed rate note to Gearty Inc. Fair value measurement considers: • • •
Nonperformance risk, including credit risk Changes in credit spreads (generally even if no changes in specific credit risk) Changes in specific credit risk (even if within the AA spread)
44
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
45
Fair Value Approaches I.
SFAS 157 describes three available techniques to measuring fair value A.
B.
Market Approach: Identify observable prices and other relevant information that is generated by market transactions involving identical or comparable assets or liabilities. Income Approach: Use valuation techniques to convert future amounts (cash flows or earnings) to a single, discounted amount. The fair value measure is based on the value that is indicated by market expectations about the future amounts. The income approach includes presentvalue techniques/option-pricing models: 1. 2. 3.
Black-Scholes Binomial models – lattice models Multi-period excess-earnings method (CON 7 specifies that adjustments reflecting systematic risk can be made to either (1) the expected cash flows or (2) the discounted rate. The risk-free rate would be an appropriate discount rate only if the adjustment that reflects the systematic risk (non-diversifiable risk) is reflected in the expected cash flows)
46
Fair Value Approaches
• Measure fair value by a valuation technique that is appropriate and for which sufficient data is available. • Multiple valuation techniques: Management should evaluate and weigh the results to determine a single best fair value measure. • The weighting process should not be mechanical and requires a significant amount of professional judgment. • Techniques used to measure fair value should be applied consistently. It is appropriate to change when the change will result in a measure that better represents fair value.
47
Fair Value Approaches ILLUSTRATION 1)
Foxy Co. is testing land and a retail store to be held and used for the purposes of impairment under SFAS 144. A two-step test is required: 1)
2)
Step 1: Foxy Co. projects cash flows it expects to realize from operating the asset group and determines that the carrying value of the asset group is not recoverable. Step 2: Foxy Co. discounts the same cash flows used in Step 1 and arrives at a value.
KEYPOINT
Determining fair value by simply discounting cash flows based on Foxy Co.’s intended use of the facility may not comply with SFAS 157.
Foxy Co. should consider whether recent sales of comparable retail stores in the area have closed at higher or lower amounts.
48
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
49
Fair Value Hierarchy – Overview I.
SFAS 157, “Fair Value Measurements” establishes a three-level hierarchy. The purpose of the hierarchy: A. B. C.
To increase consistency and comparability in fair value measures. To maximize the use of observable market data and minimize the use of unobservable inputs. To establish classification of fair value measurements for disclosure purposes.
50
Fair Value Hierarchy – Overview 1)
Input Valuation Techniques: A.
Market participant assumptions are incorporated in the fair value measurement through the inputs to valuation techniques 1.
2.
Observable inputs: Developed based on market data obtained from sources independent of the reporting entity/company Unobservable inputs: Developed based on the best information available in the circumstances, subject to cost-benefit constraint KEYPOINT
A fair value measurement should maximize the use of observable inputs
51
Fair Value Hierarchy – Overview 1)
Types of Markets (within Observable Inputs) Markets in which inputs might be observable include: 1.
Exchange Market In an “active” exchange market, closing prices are both readily available and representative of fair value a.
2.
Dealer Market: Dealers stand ready to trade for their own account; the dealers provide liquidity by using their capital to hold an inventory of the items for which these dealers make a market. Usually bid prices and asked prices are more readily available than closing prices. a.
3.
4.
Example: New York Stock Exchange
Examples: Financial instruments, commodities, physical assets
Brokered Market: Brokers attempt to match buyers with sellers. Brokers do not stand ready to trade for their own account and they will not use their own capital to hold an inventory of the items for a market. Principal-to-Principal Market: These transactions (both originations and resales) are negotiated independently, with no intermediary. Typically, there is very little information about these transactions is publicly available.
52
Fair Value Hierarchy – Overview 1.
Fair Value Hierarchy:
Level 1
Observable inputs that reflect quoted prices in active markets for identical assets/liabilities (unadjusted)
Foxy Inc.’s common stock traded and quoted on the New York Stock Exchange
• A privately placed bond of Foxy Inc., the value is derived from a similar bond that is publicly traded Directly or indirectly observable (market-based) inputs – including quoted Level 2 prices for similar assets/liabilities (adjusted) through corroboration and • An over-the-counter interest rate swap, observable market data inputs valued based on a model whose inputs are observable LIBOR forward interest rate curves. • Shares of Gearty Co., a privately held company whose value is based on Unobservable inputs (no market data, not correlated with market data) – projected cash flows. company’s own data assumptions about market participant assumptions, • A long-dated commodity swap whose Level 3 including assumptions about risk, developed based on the best forward price curve, used in a information available in the circumstances (can include the entity’s own valuation model, is not directly data inputs) observable or correlated with observable market data.
KEYPOINT Subject to cost-benefit constraints
• Level 3 is most “subjective” and therefore of greatest risk of manipulation 53
Fair Value Hierarchy – Overview
KEYPOINT The selection of appropriate valuation techniques may be affected by the availability of inputs that are relevant to the asset or the liability, as well as be affected by the relative reliability of the inputs.
• By distinguishing between inputs that are observable in the marketplace and therefore more objective and those that are unobservable and therefore more subjective, the hierarchy is designed to indicate the relative reliability of the fair value measures.
54
Fair Value Hierarchy – Overview
KEYPOINT In some cases, inputs might fall within different levels of the fair value hierarchy. The lowest level of significant input determines the placement of a fair value measure in the hierarchy. Assessing the significance of a particular input requires judgment, important for disclosures
• Certain disclosure required by SFAS 157 are applicable only to those fair value measures that use Level 3 inputs
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Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
56
Fair Value Hierarchy – Level 1 I.
Level 1 Inputs A. B. C.
Level 1 inputs are quoted prices (unadjusted) for identical assets or liabilities in active markets. Provides the most reliable fair value measure Level 1 should be used provided that 1. 2.
The market is the principal (or the most advantageous) market, and The company has the ability to access the principal (or the most advantageous) market. a.
Example: If a retail customer that does not have access to wholesale market, then the quoted prices in the wholesale market will not qualify as Level 1 inputs for that company.
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Fair Value Hierarchy – Level 1
KEYPOINT
Matrix Pricing: i. A company may measure fair value by using matrix pricing, provided that the company demonstrates that the method replicates actual prices. ii. Used to value debt securities by relying on the securities’ relationship to other benchmark quoted prices. iii. The resulting measure will be a Level 2 input. iv. Matrix pricing is a very common approach for such things as valuing bond portfolios.
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Fair Value Hierarchy – Level 1 1)
Modification of Transaction Price Presumption A.
Fair value may not equal the transaction price when: 1. 2. 3. 4.
Related parties make the transaction Bankruptcy: the transaction is done under duress (or some other urgency) Unit of account differences (transaction price includes transaction costs) The transaction is not in Principal (or most advantageous) market (retail market vs. wholesale market)
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Fair Value Hierarchy – Level 1 KEYPOINT SFAS 153: Non-monetary Exchanges (Fair Value) i. An asset is acquired or a liability is assumed in an exchange transaction – the transaction price represents the price that was paid for the asset or that was received to assume the liability (i.e., the entry price). ii. The fair value of the asset or the liability represents the price that would be received for the asset or paid to transfer the liability (i.e., the exit price) iii. The above two prices can be different.
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Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
61
Fair Value Hierarchy – Level 2 I.
Level 2 Inputs When an asset or liability has a specified (contractual) term, a Level 2 input should be observable for substantially the full term of the asset or liability. They include the following: A. B. C.
D. E. F. G.
Quoted prices for “similar” assets or liabilities in active markets Quoted prices for “identical” or “similar” assets or liabilities in markets that are not active. Not Active Markets: 1. 2. 3. 4.
Few transactions for the asset or liability Prices are not current Price quotations vary substantially either over time or among market Little information is publicly available
Inputs other than quoted price that are observable for the asset or liability (interest rates and yield curves observable at commonly quoted intervals, volatilities , prepayment speeds, and default rates) Inputs that are derived principally from or corroborated by other observable market data through correlation or by other means. Adjustments of Level 2 inputs should reflect factors such as the condition and/or location and the volume and level of activity in the markets within which the inputs are observed. An adjustment that is significant might place the measure at Level 3 in the fair value hierarchy.
62
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
63
Fair Value Hierarchy – Level 3 I.
Level 3 Inputs A.
B.
C. D.
Level 3 inputs are unobservable inputs that consider the assumptions that market participants would use in pricing the asset or liability, including assumptions about risk. Unobservable inputs should be developed based on the best information available in the circumstances, which might include the company’s own data. A company need not undertake all possible efforts to obtain information about market participant assumptions The company should not ignore market participant assumptions that are reasonably available without undue cost and effort.
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Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
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Unit of Valuation I.
Definitions A.
B.
Unit of accounting Establishes the asset or liability that is being measured at fair value for purposes of financial reporting. Unit of valuation Establishes whether the asset or liability is measured at fair value within a larger group
KEYPOINT Attribute the indicated fair value of the group to the asset or liability.
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Unit of Valuation 1)
Unit of Valuation
Depends on the “highest and best use” of the asset, which establishes the “valuation premise” used to measure the fair value of the asset. A. Highest and Best Use Use by market participants that maximizes value of asset (or asset group). B. Valuation Premise 1.
In-Use: Market Participant Synergies Highest and best use is “in-use” if: a.
2.
Asset would provide maximum value to market participants through its use with other assets as a group, as installed or otherwise configured for use.
In Exchange: No Market Participant Synergies Highest and best use is “in-exchange” if: a.
Asset would provide maximum value to market participants through its use on a stand-alone basis
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Unit of Valuation 1.
Highest Use: Real property Illustration 1 ILLUSTRATION 1
• • •
•
Foxy Co. acquires land and storage building. Observable market data indicates that nearby sites have recently been developed for residential use. The highest and best use of the land would be determined by comparing: 1) The fair value of the storage building (in-use) 2) The fair value of the land as a vacant site for condominiums (in-exchange) Regardless of the intended use, the highest and best use of the land would be determined based on the higher of those values
KEYPOINT
Highest and best use assumptions should be consistently applied to other assets in the asset group. Note: The land’s highest and best use would determine the storage building’s highest and best use.
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Unit of Valuation (i) Asset Group: Illustration 2 ILLUSTRATION 2 •
Foxy Co. acquires assets that are used together as a group (Assets X,Y, and Z). • • • • • • • •
Unit of account = each individual asset Unit of valuation = the group of assets within which the assets would be best used by market participants Highest and best use is in-use Exit market = the acquisition market Market participants are other bidders for the assets Strategic and financial buyers Strategic buyers have related assets that would enhance the value of the assets as a group, including a replacement asset for Asset Z (billing software) Financial buyers do not have related assets that would enhance the value of the assets as a group.
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Unit of Valuation I.
Asset Group: Illustration 2 (continued) ILLUSTRATION 2 (continued) Observable Fair Value Assets Strategic Buyer Group
• •
Financial Buyer Group
X
$820
$700
Y
$620
$500
Z
$160
$300
Total
$1,600
$1,500
Fair values of Assets X, Y, and Z determined based on use within strategic buyer group because that use would maximize the fair value of Assets X, Y, and Z as a group. Do not maximize the fair value of each asset individually
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Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
71
Reporting Requirements I.
New Disclosures A. B. C. D. E.
Improve transparency regarding how fair value is determined. Applies to both recurring (example: SFAS 115) and non-recurring (example: SFAS 144) fair value measurements of assets and liabilities Tabular disclosure by major category of which level in the hierarchy a fair value measurement falls Annually (and in the period of adoption), describe the valuation techniques and any changes to the valuation techniques. Provide disclosures about: 1. 2. 3. 4.
The extent to which companies measure assets and liabilities at fair value The methods and assumptions used to measure fair value The effect of fair value measures on earnings Expanded disclosures about Level 3 (non-market data) measures: a. b.
Each major category of assets and liabilities measured using a Level 3 fair value measure, a reconciliation of beginning and ending balances including total gains and losses The amount of total gains and losses attributable to the changes in unrealized gains and losses related to Level 3 input-based assets and liabilities held at the reporting date and a description of where those gains and losses are reported in the income statement.
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Reporting Requirements ILLUSTRATION: Disclosure – Recurring 1 Fair Value at Reporting Date Level 1:
Level 2:
Level 31:
12/31/XX
Quoted prices in active markets for identical assets
Significant other observable inputs
Significant unobservable inputs
$115
$105
$10
-0-
Available-for-Sale securities
75
75
-0-
-0-
Derivatives
60
25
152
$203
Venture capital investments
10
-0-
-0-
$10
$260
$205
$25
$30
Description Trading Securities
Total
Additional disclosures are required for recurring Level 3 measurements 2 Standard interest rate swaps 3 20 year energy contract 1
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Reporting Requirements ILLUSTRATION: Level 3 Recurring Level 3: Assets Measured on a Recurring Basis Using Significant Unobservable Inputs
Beginning Balance 01/01/XX Total gains or losses (realized / unrealized): Income Statement Included in Other Comprehensive Income Purchases, issuances and settlements Transfers in and/or out of Level 3 Ending Balance 12/31/XX Unrealized gain (loss) in earnings from assets still held at period end
Derivatives*
Investments by Venture Capitalist
Total
$14
$11
$25
11 4 (7) (2) $20 $ 7
(3) -02 -0$10 $ 2
8 4 (5) (2) $30 $ 9
KEYPOINT
*Derivatives assets and liabilities can be presented net for purposes of this roll-forward.
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Reporting Requirements ILLUSTRATION: Nonrecurring* Level 3: Assets Measured on a Recurring Basis Using Significant Unobservable Inputs
Description
End of Year 12/31/XX
Level 1 Level 2 Level 3 Quoted prices in Significant other Significant active markets for observable unobservable identical assets inputs inputs
Total Gains (Losses)
Long-lived assets held and used
$225
-0-
$225
-0-
($75)
Goodwill
$90
-0-
-0-
$90
($40)
Total
($115) KEYPOINT Describe the reason for the nonrecurring fair value measurement Describe the inputs and information used to develop the inputs for nonrecurring Level 3 based fair value measurements. 75
Overview Exceptions Unit of Accounting Market-based Measures
Considerations
Exit Price Market Participants Orderly Transaction Highest Use / Principal Market Transaction / Transportation Fair Value Assets
Fair Value Liabilities
Fair Value Approaches Market
Income
Cost
Fair Value Hierarchy Level I
Level II
Level III
Unit of Valuation Reporting Requirements Transition
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Transition I. Prospective II. Two Exceptions: Cumulative effect adjustments to beginning retained earnings in year of initial application: A. B.
Block discounts Issue 02-3 and Statement 155 hybrid instrument day-one gain and loss deferrals
III. Effective for fiscal years beginning after November 15, 2007. (Calendar year business will be required to apply SFAS starting on January 1, 2008).
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